Saturday, February 4, 2012

The hidden pitfalls of Basel III regulation

There is no shortage of ill-conceived regulation descending on the global financial industry. In some instances the new regulation will not only add little to improve the safety of the financial system but could actually destabilize it. One of Basel III rules for example is sure to create some potentially severe "unintended consequences".

As a bit of background, back in 2007, Citigroup was forced to take onto their balance sheet a significant amount of assets from "CP conduits" because the firm provided commercial paper (CP) "backstops" to these entities. The entities were funding themselves with asset-backed commercial paper while Citigroup effectively guaranteed that it will step in to finance the assets in case the entities could not roll their CP. And that is indeed what happened. All of a sudden Citi was saddled with large amounts of "AAA" CDO paper and other securities that weren't on their balance sheet before, even though Citi always had exposure to them. Citi was in fact financing this paper off balance sheet via their CP backstop commitment because it allowed the bank to reduce regulatory capital requirements and achieve higher returns on capital. In 2008 that action ultimately brought down the firm, with the US government forced to take a large stake in the company and providing it unprecedented financial support. RBS (taken over by the UK government) and Wachovia (taken over by Wells Fargo) both met with similar fate.

Instead of attempting to address this specific issue the
Basel III architects decided to use a blunt instrument. They put in place a simple rule stating that any unfunded contractual commitment to a financial institution must be treated as a fully funded commitment for the purposes of regulatory capital. It sounded great to many ivory tower bureaucrats, but few have realized the implications, particularly for the US. In the US the usage of revolving facilities is quite common both within and outside the financial industry. With this new rule banks will have to "put aside" the same amount of capital as they would for a fully funded loan. Therefore banks would have to charge the same interest on the undrawn amount as they would on the amount actually lent out. It's a bit like having to pay interest on your full credit card limit rather than just on the amount you borrow.

Consider a money market mutual fund for example. Often a large mutual fund would have a credit line with a bank for which it pays an unfunded commitment fee. Under the new rules funds would have to pay the full rate as though they have taken out a loan. That would be prohibitively expensive for a fund, making revolving facilities a thing of the past. Now imagine that a fund finds itself with large unexpected redemptions. Normally it would simply draw on the revolving facility to fund the redemptions and pay back the loan when its holdings of short term paper mature. Under the new regime it may be forced to sell the paper in the market at a great discount (secondary commercial paper does not trade well) and create losses for investors. A money market fund "breaking the buck" for example will panic other investors, generating more redemptions and so on. It is not at all clear how such a rule is making the financial system more stable.

Even beyond the problem of providing revolving facilities to mutual funds, Basle III will have significant implications for the corporate sector as well.

Journal of Global Finance: But the dilemma that all corporate treasurers face is in anticipating which particular financial services they will wind up paying more for—or earning less from. The Basel Committee of the Bank for International Settlements’ new rules will require all banks —including the 23 that International Paper does business with—to more than triple their core Tier 1 capital from 2% of risk-weighted assets to a minimum of 7% by 2019. Made up of common equity and disclosed reserves—or retained earnings—core Tier 1 is “the most expensive” type of capital that a bank holds, explains Peter Neu, a partner and managing director at Boston Consulting Group in Frankfurt....

...rather than rejoice at rules that are intended to reduce overall risk in the global financial system, senior managers of banks around the globe that are starting to comply with Basel III are quick to identify a litany of brutal impact points for their corporate clients, ranging from a drop in already-low interest rates on deposits to dramatic increases in interest rates on loans.

Even undrawn lines of credit will become more expensive and difficult to maintain. Banks will be required to treat 10% of short-term lines and 5% of long-term ones as if they were already drawn, according to Neu. The most that clients will be able to borrow from those lines will be 90% and 95% of their outstanding balances, respectively. “You cannot use this cash for other purposes. ...

The new rules will impact numerous business activities - from bank owned lease companies to trade finance.

Journal of Global Finance: In trade finance, where the liquidity ratio under Basel III would imply a fivefold increase in interest rates, some corporate treasurers are considering taking their business to insurance companies that issue surety bonds covering trade transactions. They are even looking at ways to serve as their own guarantors.

The bewildered public and some ignorant politicians continue to play the blame game for the slow economic growth and anemic hiring in the US. But at least a part of the answer can be found in the uncertainty associated with and the unintended consequences of the new regulation meant to cure all ills of the financial industry. Applying blunt instruments from Basel Switzerland to the US financial and corporate sector will damage numerous successful practices that served US commerce well for decades.